Six Steps to Redefine ‘Pay for Performance’

This article originally appeared on Robin A. Ferracone’s “Executive Pay Watch” blog on Forbes.com.

As we wind down for the holidays, and put the first year of Dodd-Frank behind us, now is a great time to look forward and backward. I am thrilled to introduce our guest blogger Ken Daly, president and CEO of the National Association of Corporate Directors (NACD), the nation’s largest member-based organization for corporate board directors, Ken is a recognized expert on corporate governance, executive compensation and corporate board transformation.

I am sure that we can all agree that “pay for performance” has become the buzzword for 2011. Compensation committee members who are active with NACD often tell me that their compensation objective is to award “pay for performance.” Of course, as someone who lives and breathes corporate governance, this is music to my ears.

NACD has been preaching pay for performance since our first Blue Ribbon Commission on the topic of executive compensation two decades ago—and repeated with every new edition over the past several years. After all, directors represent shareholders, who naturally favor performance-based pay. And since investors only make money when the company performs—it stands to reason that they would want the same approach to executive pay.

Clearly shareholders don’t want directors to “pay for failure,” and in 2012 we may see more directors “voted off the island” if they don’t align pay for performance and communicate their pay decisions to investors. And now, with the Securities and Exchange Commission determined to mandate disclosures on “pay for performance” in 2012, the drum beat for performance-based pay is getting louder.

The Traditional Definition of “Pay for Performance”

But not so fast! During the recent holiday season I had a chance to step back from the buzzwords and really think about it. What do we mean by “performance?” Shareholders generally define this as total shareholder return in relation to peer companies—namely the appreciation of stock price over a specific period, plus dividends, as compared to peers. Regulators are most likely to go along with that definition.

Fair enough. Yet an important nuance is missing here. The definition of pay for performance can and should vary by company. Remember, Total Shareholder Return (TSR) cannot be calculated by business unit, it requires the entire company. Also, the period of time chosen may be very short. And this is a backward looking measure. There is no consideration of future potential (unless that is impounded in the stock price, not always the case when it comes to our stock market, driven as it often is by a herd mentality.)

Here too, one size (and one formula) does not fit all. And hence my caveat emptor—a warning to the buyers of executive talent. Promising “pay for performance” to shareholders, or worse yet regulators, without defining the terms can lead to trouble.

Potential Dangers of “Pay for Performance” Determined by Investors

I have witnessed several troubled scenarios over the years involving investor communications. One example includes a company with a highly effective CEO—one who has strong relations with employees, lenders, customers and some key shareholders. The board says they will structure the CEO’s pay based on performance, but the board does not disclose any specific share-based metrics beyond the ones included in its proxy filing.

Behind the scenes, the board has set a number of internal goals that lead to a long-term sustainable company. However, the board does not use a reporting format to disclose these to shareholders or to regulators. In the course of the CEO’s first year the company makes a number of capital investments that have a payback of five years.

In this scenario, the CEO, in the eyes of the board, has performed well, because these investments will benefit the company long-term. However, for the first year of the payback period, the stock price declines, because the market does not appreciate the value of the capital investments; the market sees only a decline in earnings and fears the worst. Because the board had not disclosed and communicated all aspects of pay and performance, investors unfairly accuse the board of paying for failure.

Potential Dangers with “Pay for Performance” Designed by Regulators

I hope I don’t insult anyone’s intelligence if I remind you of the unintended consequences of federal mandates. Need I say 162(m)? Twenty years ago, most CEOs had salaries of well under $1 million per year. Then the Internal Revenue Service, implementing a provision of The Omnibus Budget Reconciliation Act of 1993, created Section 162(m). This new tax code section removed the deductibility of pay for executives unless their pay was approved by an independent compensation committee. Disclosures of the $1 million-plus packages created a demand among CEOs to top that mark, making $1 million the new floor rather than a ceiling.

So the danger with having a pay for performance mandate enshrined into law by the SEC rule is clear. The SEC will define what performance means and boards will try to adhere to it. If they had more stringent or comprehensive standards for measuring performance these could get lost in the rush to have “pay for performance” designed by Congress. Probably not the best long-term solution!

Six Steps to Redefine “Pay for Performance”

I can’t take credit for all of these insights. I have come to them from serious reflection grounded in extensive dialogue with board leaders, as well as deep primary and secondary research. By dialogue, I’m referring to the deliberations that led to the 2010 Report of the NACD Blue Ribbon Commission on Performance Metrics, co-chaired by John Dillon and William White. In this report, stakeholders and thought leaders agree that directors need to take six measurable steps that go far beyond the simplistic cry for aligning “pay for performance.” These steps include:

1. Understand and agree on the company’s key performance metrics. These key metrics, set for both the enterprise as a whole and for major business units, should be used to track progress.

2. Establish company performance metrics to cascade throughout the entire enterprise. The board should ensure that management has used the metrics to establish more robust and detailed metrics at lower levels.

3. Track company performance against metrics on an ongoing basis. Metrics need to be set annually and monitored over time.

4. Establish consistent and appropriate executive performance metrics. These measures should be used not only for compensation of top officers, but also for managers throughout the organization.

5. Reward executives based upon performance as measured by appropriate metrics. Determine compensation payments based upon an assessment of performance, including consideration of risk, for top officers and other levels of management.

6. Communicate with shareholders regarding how the company has paid for performance. Use clear language to convey the reasons and results of pay.

As you can see, these steps use well-defined metrics that are defensible and encourage ongoing communications between shareholders and directors. At the end of the day, the best board/shareholder relationships avoid any hidden dangers in the dialogue. This relationship is evolving and will continue to benefit from disclosure, transparency, and clarity. As we wind down the most interesting year in proxy season history, fasten your seatbelts—2012 promises to hold many surprises in terms of who stays and who goes.

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